So Now It Is All About ExportsGDP = Household Consumption + Investment + Government Consumption + Net Trade (Exports – Imports)

Now if household and government consumption are falling systematically, the only factor which can give a direct boost to GDP is the relative movement in exports and imports. Positive movement here can stimulate investment in the export (or tradeable) sector as expectations build for increased demand.

Total Investment = Investment for Exports + Investment For Domestic Demand.

While Italian exports surged back after the financial crisis recession they never in fact attained their pre-crisis level, and now they are once more declining again. In addition, even though Italy’s goods trade deficit has reduced substantially over the last 12 months, it is still a DEFICIT.

Just Not Sufficiently Competitive?

As we can see in the chart on the right, the Italian economy was on an unsustainable path from the end of 2009 to mid 2011, as excessive government spending fed an import surge. As government spending was cut this import boom burst, and domestic demand collapsed, taking the country deep into recession.

How To Define Competitiveness?

The REER (or Relative price and cost indicators) aim to assess a country's (or currency area's) price or cost competitiveness relative to its principal competitors in international markets. Changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends. The specific REER for the Sustainable Development Indicators is deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness. (Eurostat Definition)

The issue of competitiveness has become one generating more heat than light in debate during the current crisis. The validity of one commonplace measure (REERs) widely used historically has been repeatedly questioned. In my opinion such questioning has been largely motivated by ideological and political motives in contrast to scientific ones. In fact the evidence is clear enough.

Output & ProductivityHigh output per worker and high wages are perfectly compatible. The road to achieve this win-win combination is through raising productivity, thus maintaining unit labour costs constant, or even reducing them.

As can be seen from the accompanying charts, Germany achieved this combination between 2000 and 2008, while Italy didn’t. In Italy productivity stayed pretty much constant while unit labour costs rose, meaning salaries rose without the accompanying productivity, while in Germany unit labour costs stayed constant while productivity rose. This also gived the lie to the “cheap German wages” argument, since if wages hadn’t risen then ULCs would have fallen, which they only did briefly between 2006 and 2008.

The problem in part is that value added is often a sectorial issue. For example agriculture and construction have historically been low value added and often high unit labour cost sectors, whereas petrochemicals or biotechnology are high value added but also often low ULC sectors, despite the fact that wages are higher.

Naturally most societies would like to have a large proportion of high value added activities, and a comparatively small proportion of low value added ones. But this isn’t as straightforward as it seems, since the transition from agriculture to biotechnology doesn’t move along what we could call a smooth production function. Namely you can’t simply transfer workers from one section to the other. It ain’t that easy. The large number of construction workers recently displaced in Spain can’t simply move into machine tool manufacturing, for example.

A countries ability to engage in what are high value activities at any moment in time depends on key factors like the skill, education and experience levels of the workforce, and these change only slowly. Critically the distribution of these factors depends to some extent on the age structure of the population.

But in part the level of unit labour costs depends on the level of international competitiveness, which in part depends how much of the economy is in the tradeable sector and how much in the non-tradeable part of the economy. By tradeable we mean in competition with other producers or service providers beyond the national frontier.

The key mechanism assumed here is that the tradeable sector, being exposed to external competition, by definition needs to be more competitive to survive.

So a measure of a country’s lack of international competitiveness isn’t only that exports are too small, it is also that imports are too big, which is another way of saying that the domestic tradeable sector isn’t big enough. Normally this loss of competitiveness is associated with a growing trade and current account deficit, which means the process of non productivity supported rising living standards can only continue as long as some external agent is willing to finance it. When confidence that the process is sustainable subsides, people cease financing, and a crisis occurs. This is what happened to Italy in the summer of 2011.

Export Dependency and International Competitiveness

But now I would like to introduce an additional concept which is generally not accepted in mainstream economic theory, the idea of export dependent economies. Basically the idea is that as populations age, demand for credit and with it the rate of increase in domestic demand wanes. As can be seen in the chart on the right below, household consumption in Italy surged in the 1990s, and the rate of growth in consumer demand was quite rapid. The consumer boom was also linked to Italy’s last housing boom. Then between 2000 and 2007 something changed, and the growth rate slowed. Any internally coherent macro economic theory needs to be able to explain this change. Then following the global crisis household consumption slumped, recovered slightly and then slumped again.

So if we go back briefly to the earlier chart on the composition of GDP, we can perhaps formulate a new and better definition of international competitiveness, which would be having an export sector which is large enough and growing dynamically enough to produce GDP growth in an environment where consumer demand weakens as populations age.